Question
A very successful and profitable firm is currently considering a new, large investment project that could be initiated at the start of 2021. The project
A very successful and profitable firm is currently considering a new, large investment project that could be initiated at the start of 2021. The project involves the acquisition of a plant, which requires an initial outlay of 420 million. Although it is not clear for how long the project will last, there is an expectation that over the first six years of the project its initial capital investment should be fully depreciated. The firms accountants have prepared the following projections on expected sales and cash flows, and information on the cost of capital of the company:
Table 1. Sales and cash flow projections
2021 2022 2023 2024 2025 2026
Sales 110 148 151 135 142 145
EBITD 60 75 80 70 70 75
Depreciation (70) (70) (70) (70) (70) (70)
EBIT (10) 5 10 0 0 5
Tax expense 2 (1) (2) 0 0 (1)
EBIAT (8) 4 8 0 0 4
Table 2. Cost of capital
Risk-free Rate (Rf) 1% Project Cost of Debt (Rd) 5% Market Risk Premium 5% Marginal Corporate Tax Rate (Tc) 20% Asset Beta of comparable companies 1.1
Required:
Carry out the following calculations, always assuming that cash flows occur at the end of their respective years:
(i) Estimate the NPV of the investment project at the start of 2021 if it is 100% financed with equity and assuming that the project is terminated at the end of 2026. Show and explain your calculations and comment on your findings.
(10 marks)
(ii) Use the WACC method to estimate the NPV of the investment at the start of 2021 assuming that it is financed 55% with equity and 45% with debt and that the project is terminated at the end of 2026. Show and explain your calculations and comment on your findings.
(10 marks)
(iii) Calculate again the NPVs of parts (i) and (ii) by assuming that the project is not terminated in 2026 and that, instead, it is expected to produce the same cash flow (i.e. with zero future growth in cash flows) as that for the year 2026 in perpetuity. Show and explain your calculations and comment on your findings.
(10 marks)
(b) What are the main assumptions underlying standard applications of the WACC method? Are these assumptions plausible, also in light of the existing empirical evidence? In the alternative APV method, it is often assumed that the tax shields should be discounted using the cost of debt. Do you think this a reasonable assumption in real- world, practical applications?
[Word limit: 350 words]
(20 marks)
(c) Compare and contrast the assumptions and implications of the trade-off theory with those of the pecking order theory of capital structure. Briefly highlight evidence that supports the pecking order theory while being inconsistent with the trade-off theory.
[Word limit: 300 words]
(15 marks)
(d) Empirical tests of the (dynamic) trade-off theory are often based on estimations of the following dynamic regression model:
=( )+ 1 1
Explain the logic behind this model and carefully describe each part of it (except uit), with a particular focus on and Levit*. Let us assume that we have estimated the model above and found to be equal to 20%. What do we learn from this estimation? Is our finding consistent with the trade- off theory?
[Word limit: 350 words]
(20 marks)
(e) Your company has hired a financial consultant to better understand whether and how your companys capital structure, which only includes equity, can be enhanced. The consultant is convinced that your company should significantly increase leverage to a very high level and borrow as much as possible. The consultants conviction is based just on two considerations:
- The effective tax advantage of debt (T*) is positive; - Since T* is positive, the value of your company is positively related to the level of debt. In your opinion, is the consultants analysis logically sound and comprehensive enough to provide reliable advice? If not, what is missing from the analysis? Provide some brief suggestions as to how the analysis could be improved. [Word limit: 300 words]
(15 marks)
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started